Be Prepared For More Tax Audits

I am an Eagle Scout. I spent over 15 years with the Boy Scouts. During that time, I was taught three important things by that great organization: Invest in a warm sleeping bag; always bring a compass; and don't eat the eggs made by that kid with the runny nose. The Boy Scouts also taught me a lesson I use every day as a small business owner: Be prepared.

This lesson is more important than ever. Now that Apr. 15 is behind me and my tax returns filed, I've just read a report that claims that the Internal Revenue Service has significantly increased its audit hours of small businesses over the past five years. Do I believe that my little 10-person company will be targeted by the IRS? Well, if someone like Tila Tequila can become rich and famous, I guess anything is possible in our great country. I must be prepared.

The IRS denies this. It claims that back in 2005 it made a big push to close old audits that incurred more hours and that this is skewing the data. I don't buy that explanation. I think the chances of my company being audited in the next few years are much higher. Why?

For starters, the deficit is projected to grow to $7.4 trillion through 2018. That doesn't count the money I'm going to owe for my kids' college tuition. Maybe these projections are wrong. Maybe the economy will expand so much that this deficit will go away. Maybe the Mets are going to finish over.500 this year. When business owners such as myself need to scrape up cash to pay our bills, the first thing we typically do is increase our customer-collection activities. Doesn't it seem inevitable that the government will be doing the same thing?

The atmosphere's certainly right to beef up the IRS, too. Federal workers are experiencing a boom, both in hirings and pay levels.In fact, as of June 2009, the federal government had added 192,000 jobs to the payroll while the private sector had lost 7.3 million jobs since the recession began.The trend continues.Opponents of the health-care reform act have claimed that the IRS will need to hire more than 16,000 new workers to enforce the resolution. Others have vehemently disputed that claim. It doesn't matter. The fact is that, in this age of big government, the number of IRS agents is bound to expand. Which means more auditing opportunities for them. And more risk for me.

Uncover problems before the IRS does

To make things worse, my company's tax return is full of red flags. I operate a home office. I employ subcontractors. I take deductions for frivolous subscriptions such as Bloomberg Businessweek and Rush Limbaugh's newsletter. I hide extra profits I make from my daughter's Girl Scout Cookie sales. I donate to questionable charities such as the 76ers' season ticket plan. The IRS has been increasing their investments in technology and other tools for finding high audit potential returns such as mine. Inevitably my number's going to come up.

So what do I do? Exactly what my 20-something mentors at Boy Scout Troop 656 taught me when I was a teenager: Drink vodka because it's less noticeable on my breath. Also: Be prepared.

I'm keeping a much closer eye on my books than ever before. I'm reading my general ledger every month. Sure, it's not as much fun as reading that recent biography of Oprah. But it's necessary. And probably just a wee bit more accurate, too. I'm doing my own little audit all the time. I'm often finding interesting stuff that needs fixing. Maybe I shouldn't be charging all those iTunes purchases to "travel and entertainment" expenses. Perhaps the cash payment I received last week from that client isn't properly recorded. If I'm expecting the IRS to visit me one day, I want to make sure they don't uncover these things before I do.

I admit to being pretty organized. I'm proud to say that I can find just about any invoice we've paid over the past five years faster than I can find the TV remote in my living room. My bookkeeper does a great job filing everything where it can be easily located. My accountant prepares a pretty clean return and we make sure it can be tied back to our books. We don't have a lot of adjusting entries. Most of the accounting work is done in a timely fashion—not long after the fact. In the event of a visit from the IRS, this will save my people a lot of time getting information and answers to the auditor.

If you do decide to roll the audit roulette wheel and take a chance that the IRS auditor will never find that deduction you took for the family vacation to Mexico last Christmas, you'd better have a good explanation. That makes all the difference between a disallowed deduction and criminal negligence. Every questionable item that I find during my monthly general ledger review has to have a good business reason behind it.

Retain an accountant you can trust

Smart business owners I know are also very familiar with their tax exposure areas. One of my clients, a manufacturer, knows that the way it value its inventory will likely be looked at closely. Another client has numerous tax entities that do business with each other. As I said earlier, I do a lot of work from a home office and I employ subcontractors. Most of the business owners I work with are guilty of taking a questionable deduction or two. These are usually immaterial compared to some of these other exposure areas. They know these areas and usually document, with their accountant, their accounting policies for those specific areas.

Which assumes—and this is a big assumption—that your accountant is someone you can trust. A big further way to avoid getting spanked at a tax audit is to have an accountant who will go to bat for you. Some tax accountants run for cover the minute you get notice of an audit. You want a Tom Hagen by your side, not a Freddie Corleone. My last accountant was like Freddie—without the Vegas connections. I changed accountants recently and know that my new guy will be in the trenches with me.

Believe it or not, you don't have to be accounting for everything the right way either. The key is consistency. The manufacturer mentioned above may not be capitalizing all inventory expenses but as long as he's been doing it the same way over the years, his auditor won't be able to accuse him of fixing the books to avoid taxes. He can argue that because of his consistency, taxes were ultimately paid as the inventory was sold. I'm not saying that he'll always win this argument. But being consistent is always a good defense against a tax audit. Wish I could say the same about my softball playing.

Becoming an Eagle Scout didn't get me more lucrative job offers. It definitely did not get me any more girlfriends. It did teach me to expect and prepare in advance for potential problems, such as the increased likelihood of a tax audit. That education was even worth occasionally eating eggs made by the kid with the runny nose.

    Before it's here, it's on the Bloomberg Terminal.